The madness of fixed exchange rates: The spectre of intervention

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Only floating exchange rates will allow the world to steer between the Scylla of capital controls and the Charybdis of recurrent financial crisis and wealth destruction, argues Bernard Connolly.

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Monetary historians cite "unusually favourable political circumstances" to explain the emergence of the classical gold standard. Its demise, four decades later, was the direct result of unusually unfavourable political circumstances , the outbreak of World War 1. Was there any connection between the monetary regime and the slide to war? What lessons are there for today's world of restored global capitalism, a world in many ways reminiscent of the late 19th century? The most striking is that the maintenance of a world capitalist order is incompatible with fixed exchange rates.

The classical gold standard worked relatively well for many of the "emerging markets" of the day, at least for those marked by political stability and English-based legal systems (the British Dominions and the US) and some South American countries.

These countries had apparently unlimited natural resources and a ready supply of new immigrants. At least by post-1914 standards, their governments had little debt and interfered little in private-sector economic activity. They had high rates of return on capital, current-account deficits, capital-account surpluses and high rates of growth. True, they suffered deflations when world gold supplies could not keep up with world economic growth. But in periods when the world interest rate, affected by developments in both emerging and mature economies, was too low for them, the elasticity of factor supply prevented serious overheating.

Dangerous side-effects

But for the "core" countries, Britain and France from the beginning and, increasingly as time went by, Germany too, the impact of the emerging markets of the day in pulling up the world rate of interest and sucking capital out of the core often created deflationary pressure that could be alleviated only by carving out large export surpluses. By the 1890s, before new gold discoveries eased matters somewhat, the struggle to create and maintain these surpluses had led to protectionism, to cartelization (in Germany at least), and to the scramble for colonies as vents for the export of surplus goods and surplus labour , all these dangerous phenomena justified by the imperative, given the existence of something like a world rate of interest, of maximizing the returns to scale. At this time international economic relations had a nakedly conflictual basis, reflecting a social Darwinism that saw the world in terms of a fight to the death between rival, inherently nationalistic, economic and social systems.

At the same time, the strains of maintaining excessively high interest rates to protect convertibility led to domestic social and political conflict. Throughout Europe, political liberalism was in retreat, while more extreme forms of socialism and reactionary conservatism began to thrive. Both the latter ideologies sought to find scapegoats for economic woes: Jews were a favourite target. And class war within nations as well as economic and commercial rivalry among nations became an increasingly grave threat.

The enemies of capitalism

Does this sound uncomfortably like parts of a standard Marxist critique of capitalist imperialism? If so, it has to be responded to , but by pointing to the perils of fixed or quasi-fixed exchange rates in a world capitalist system. Instead, the latter-day enemies, in effect if not always in intention, of capitalism are doing the opposite in the wake of the emerging-market financial crisis.

The lesson of the classical gold standard and the interwar episode had already been misread by the architects of the Bretton Woods system. They pointed not to the ills of the classical gold standard but rather to those of the 1930s. They contended that "competitive devaluations" created protectionism and depression and hence led to World War II. They failed to recognize that the factors that contributed, via the classical gold standard, to World War I were similar to those that led to the breakdown of the interwar gold standard: international capital flows in a regime of credibly fixed exchange rates made deflation , and thus debt problems and economic, social and political strains , the inevitable consequence of any dip in the domestic rate of return on capital relative to the world rate of interest. "Competitive devaluation" in fact provided some relief from the strains that led to the depression of the 1930s by engineering, in a non-cooperative way (always the best) a world monetary expansion; unfortunately, it came too late.

But in an era cruelly dominated by collectivist thinking, when capitalism was a dirty word in much of the western world, Bretton Woods naturally chose to institute a system of fixed rates rather than restore free capital movements. This tragedy led governments to extend their wartime control over economic life and condemned hundreds of millions of people outside the favoured industrial nations to almost two additional generations of poverty.

The call for control

Not until the 1980s did a worldwide move away from collectivism allow greater freedom of capital movement. Since then, relatively free international flows of capital have been the most desirable and beneficial signature of a more liberal world order. They have been largely responsible for the successful battle against inflation and fiscal profligacy in so many countries of the world, and they have helped produce a spectacular increase in living standards in parts of the developing world while easing the financial problems posed by ageing populations in the mature economies.

Yet, since the onset of the Asian crisis, more and more voices have been raised to call for a return to capital controls. This would restore governments and bureaucrats to positions of lost influence and would mean decisions being taken again by a few dozen members of the international political, bureaucratic and business elite rather than by many millions of firms and households.

But if capital controls, worsened economic performance throughout the world and a return to national or regional economic rivalry , with who-knows-what dire political consequences, are to be avoided, the fallacy of fixed exchange rates must first be exposed.

Key features of today's dynamic world include the development of emerging markets and transition economies, the seemingly perpetual self-regeneration of the US economy and the structural changes that will eventually stir the continental European economies (however much the apparatus of the single currency is deployed to hold back those changes), rapid technological advance and shifting patterns of consumer demand as societies evolve.

In short, the pattern of comparative advantage among nations is constantly changing. Many of these changes are linked to government policies. This is most obvious in the case of emerging markets and transition economies: shifts in policy that allow the integration of the domestic economy into a capitalist, market-based world economic order obviously have dramatic effects on the rate of return on capital in the economy concerned.

But the same is true even in mature economies. During the grim 1970s, for instance, the aping by Heath, Nixon and Carter of aspects of the collectivist, consensus models of continental Europe led to sharp reductions in the prospective rate of return on capital in the UK and the US. Reversals, beginning in the early 1980s, of those mistakes led to upturns in the rate of return.

Today, in a mature country such as the UK for instance, the government still claims that its structural policies in a whole host of areas , the labour market, social security and taxation policy, competition policy, education policy and others, even cultural policy , can make a marked difference to the country's structural economic prospects.

What is true of a country that is relatively successful in structural terms is even truer of Japan and the countries of continental Europe, where radical structural change is urgently needed. In effect, what every political party in a stable capitalist country in modern times says to the voters is: "Elect us and we will increase the rate of return on capital in this country" (not all parties are ready to use such terms, of course, and even fewer of them will actually succeed in their policies, but that is what they all mean).

In other words, governments are constantly striving to create the conditions in which entrepreneurs produce nationally idiosyncratic shocks to the rate of return.

Dangerous illusions

This has important implications for the world monetary regime. The rate of return on capital will constantly be shifting among countries. If capital is free to move, then the rate of interest (adjusted for credit risk) will be able to differ among countries only if exchange rates are expected to move. If stable exchange rates are anticipated, then disasters such as the Asian financial crisis become unavoidable. Global capitalism may not be able to survive many more such disasters. Only exchange rate fluctuations will allow the world to steer between the Scylla of capital controls, international or supranational "coordination", Keynesian fiscal policies and bureaucratic collectivism and the Charybdis of recurrent financial crisis and wealth destruction.

If policy or other changes increase a country's prospective rate of return on capital, real interest rates must initially rise and the real exchange rate must initially appreciate abruptly if there are not to be the all-too-familiar side-effects of asset-price bubbles, over-expansion of capacity, misallocation of capital inflows and of physical investment and foolhardy borrowing and lending behaviour by banks and their customers.

Put simply, the most dangerous illusion in a capitalist world is that a whole economy can make excess profits from investing at a rate of return above the world rate and borrowing at the world rate of interest. Whether we like it or not, it is the essential paradox of capitalism that what is good news for some is bound to be bad news for others.

It should matter not one jot that some "efficient" existing activities are thereby squeezed out as real interest rates rise and the currency appreciates, even if, as should happen, these movements are reversed after a relatively short time. No firm should be allowed to rest on its laurels (most firms want to, of course: hence the self-serving complaints from established, rent-seeking firms and their anti-capitalist bureaucratic allies about the supposed iniquities of "short-termist" financial markets, "destabilizing" capital flows and "excessively volatile" exchange rates).

If global capitalism is to work, then the price mechanism must be allowed to work. For any non-Marxist, the two most important relative prices in any economy are the price of tomorrow's output in terms of today's (the real interest rate) and the price of domestic output in terms of foreign output (the real exchange rate).

If these relative prices are not allowed to adjust swiftly via changes in nominal interest rates and exchange rates, then boom-busts, bringing much less benign adjustments, will follow. If Marxists are not to be proved right, and if capitalism is not to "collapse under the weight of its own contradictions", then the contradiction between freedom for capital to flow between countries and insufficient freedom for interest rates and exchange rates to move in response must be recognized and resolved.

Bernard Connolly is an executive director of AIG International